Reading 45: The Case for International Diversification－LO efficient, justify, impact

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 17: Portfolio Management in a Global Context
Reading 45: The Case for International Diversification
LOS d: Explain and justify the impact of international diversification on the efficient frontier.

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Which of the following most accurately represents the relationship between the global efficient frontier and a domestic efficient frontier? The global efficient frontier will contain portfolios with:

A) higher risk for a given return and higher return for a given risk level than portfolios on the domestic efficient frontier.

B) lower risk for a given return and lower return for a given risk level than portfolios on the domestic efficient frontier.

C) higher risk for a given return and lower return for a given risk level than portfolios on the domestic efficient frontier.

D) lower risk for a given return and higher return for a given risk level than portfolios on the domestic efficient frontier.

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Answer and Explanation

Due to the low to moderate correlations between global markets, the global efficient frontier will contain portfolios with lower risk for a given return and higher return for a given risk level than portfolios on the domestic efficient frontier.

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Relative to the efficient frontier that includes only domestic investments, the efficient frontier that also includes foreign investments will plot to the:

A) left and bottom.

B) right and bottom.

C) left and top.

D) right and top.

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Answer and Explanation

If return is plotted on the y-axis and risk is plotted on the x-axis, the efficient frontier that includes foreign investments will plot to the left and top of the frontier that includes only domestic investments. This means that the global frontier has lower risk and greater return than the purely domestic efficient frontier.

tycoon

The efficient frontier that includes domestic and foreign investments will reflect which of the following characteristics of foreign investments:

A) higher return opportunities and higher correlations.

B) lower return opportunities and lower correlations.

C) higher return opportunities and lower correlations.

D) lower return opportunities and higher correlations.

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Answer and Explanation

The efficient frontier that includes foreign investments will result in higher returns and lower risk than the frontier that includes only domestic investments due to the lower correlations and higher return opportunities available in foreign markets.

tycoon

Relative to the efficient frontier that includes only domestic investments, the efficient frontier that also includes foreign investments will have:

A) higher return and lower risk.

B) higher return and higher risk.

C) lower return and higher risk.

D) lower return and lower risk.

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Answer and Explanation

Due to low correlations, the efficient frontier that adds foreign investments to a domestic only portfolio will have higher returns and lower risk over time.